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Microsoft Bears Underestimate the ‘Enterprise Moat’ January 28, 2011

Microsoft reported a solid fiscal second quarter on Thursday with revenue and earnings that were generally above consensus estimates.  However, concerns over relatively tepid growth in the Windows segment overshadowed positive results elsewhere in the eyes of market participants leading to a nearly 4 percent drop in the stock price today.

Since there are numerous articles already published detailing Microsoft’s results for the quarter, we will focus the majority of our attention toward an examination of some of the business issues that are most often cited by those who are bearish on the company’s outlook.  For more background on the investment thesis for Microsoft, please read our article from August 2010.

Fear of Tablets Overshadows Positive Results

The general market sentiment toward Microsoft appears to be based on fears that the company’s longstanding moat in Windows will be rapidly eroded by the entry of new tablet devices led by Apple’s iPad.  This concern has largely overshadowed positive developments that have emerged in recent quarters including significantly higher overall operating margins, shipment of over 8 million Kinect units in the final sixty days of last year, strong performance in the Business Division led by Office 2010, and continued positive results in Server & Tools led by products such as the SQL Server database.  In addition, the company repurchased $5 billion in stock and recently increased the regular dividend.

The tepid growth in the Windows segment reflects an overall slowdown in PC unit shipments with a more pronounced slowdown in PC sales to consumers.  According to the company, business PC shipments grew more quickly than consumer shipments as companies continued to combine hardware refreshes with adoption of Windows 7.  In absolute terms, PC shipments of 90 million globally was still a record high, but lower end netbooks are in decline.  Netbooks sold to consumers are in direct competition with tablets such as the iPad and often serve as secondary devices in addition to a main PC.

Focus on the Enterprise

There is no doubt that in the consumer market, low end netbooks are subject to significant competition from the iPad and other tablets.  Consumers often purchase netbooks as secondary devices and may prefer the lighter and more compact form factor offered by tablets depending on expected usage patterns.  However, with all of the scrutiny of the consumer, we should not forget that Microsoft’s success is largely tied to what happens in the enterprise.

According to Microsoft’s conference call presentation, 300 million Windows 7 licenses have  been sold over the past year and 90 percent of enterprise customers have started their formal migration to Windows 7.  At this point, Microsoft reports than over 20 percent of PCs are running Windows 7 which obviously means that the refresh cycle for Windows 7 is not over and enterprise customers intend to move forward with migration in the coming months.

We can validate the continued prevalence of Windows in the enterprise by observing the fact that Microsoft’s Server & Tools and Business Divisions continue to turn in very strong results.  The Business division in particular is worth examining because it is actually Microsoft’s largest segment both in terms of revenues and operating income.  Office 2010 appears to be a major hit both in the consumer and business markets and this trend should accelerate as companies adopt Windows 7 and combine the operating system migration with an upgrade to the new office suite.

Microsoft’s Consumer vs. Enterprise Moat

It is obvious that Microsoft enjoys a powerful moat in both the consumer and business markets, but there is no denying the fact that the moat is under major attack in the lower end netbook market and this will impact results if the trend persists and Microsoft fails to adapt to the tablet form factor.  However, Microsoft’s moat in the enterprise does not appear to be at nearly as much risk.  While Apple is making great headway in enterprise adoption of the iPad, there is limited evidence to suggest that the device is a substitute for PCs within the enterprise or that Microsoft’s powerful moat in Server & Tools or Office is at imminent risk.

Enterprise Inertia and Risk Aversion

To understand why Microsoft’s moat in the enterprise is so strong, one needs to examine the nature of software in business environments. An enthralled consumer can set aside his PC and head for the Apple store to wait in line when the new iPad comes out this spring, but for grizzled and skeptical IT managers, the situation is more complex and perilous.

In many organizations, Microsoft has long supplied the operating system and business software used to run critical systems and is deeply embedded in the corporate DNA.  Much media attention today focuses on threats from cloud computing and the opportunities for Google or to take share from Microsoft, but analysts typically ignore the depth and volume of customized software that is built into the Microsoft ecosystem.

Business software takes on a life of its own over many years and becomes embedded into critical processes.  Microsoft products have long allowed for customization through extensible architectures that permit programmers to leverage the operating system, productivity applications such as Word and Excel, business applications such as Microsoft CRM, and server tools such as SQL Server to facilitate unique processes.  In many organizations, two decades of custom code may exist within the Microsoft ecosystem.

When faced with the decision of whether to move to the cloud, which often provides very legitimate benefits to organizations, companies will naturally first look at their current investment in software and attempt to determine whether any of it can be leveraged.  Since Microsoft has not ceded the cloud to competitors without a fight, a decision facing information technology executives becomes whether to leverage some of  their existing investment by utilizing Microsoft’s cloud solutions or scrapping the existing code and starting from scratch entirely.

Moat May Take Years to Breach

No moat is immune from attack by superior products offering significant advantages to those who make a switch.  If Microsoft’s competitors offer businesses compelling choices that provide either cost advantages or customer service benefits, eventually market share will be lost as  companies determine that the costs of staying with legacy software outweigh the massive costs of making a switch.  However, contrary to popular belief, Microsoft is not simply sitting still and passively waiting for competitors to take market share.

Based on actual data, it is not possible to make a compelling argument that Microsoft’s moat has already been breached.  The company continues to turn in very strong results by nearly any measure, including expansion of operating and net margins.  Few companies without a moat can turn in net margins in excess of 30 percent.  Lacking data to make the case, bears need to present a compelling case that Microsoft’s moat will be breached in the near enough future to justify a P/E ratio of approximately 10 when excess cash is excluded from the calculation.

The bullish investment thesis for Microsoft does not need to make heroic assumptions to be correct.  For example, we need not assume anything spectacular for the Kinect device going forward even though it appears that Microsoft has likely grown Entertainment & Devices into another division that could deliver $2 billion or more in operating income annually.

At the current valuation, the investment thesis must focus on whether Microsoft’s moat is not only likely to be breached but largely destroyed over the next three to five years. If such an outcome occurs, Microsoft’s margins will plummet and today’s valuation may look rich based on future earnings.  While anything is within the realm of possibility however remote, the weight of all the evidence is that Microsoft’s moat, even without much technological progress, will remain intact for at least the next five to seven years and most likely much longer.

Microsoft Fiscal Q2 2011 Resources:

Form 10-Q Filing
Press Release
Conference Call Transcript
Conference Call Presentation (PowerPoint)

Disclosure:  The author of this article owns shares of Microsoft Corporation.  From 1995 to 2009, the author was involved in building business applications primarily within the Microsoft ecosystem.

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Investors Price In Failure of Windows Phone 7 Rollout October 5, 2010

Microsoft will officially launch Windows Phone 7 in New York on Monday, October 11 with AT&T expected to participate as the “premier carrier” for Windows Phone 7 devices.  According to a recent report, T-Mobile is also expected to participate in the launch.  Initially, phones running Microsoft’s new operating system will only be available on GSM networks such as AT&T but support for CDMA carriers such as Verizon is expected in the first half of 2011.

Phone Strategy Under Attack

Microsoft’s strategy in the smart phone market has been under attack in recent months and bearish sentiment on Wall Street increased yesterday after Goldman Sachs downgraded the outlook on the company’s shares to “neutral”.  In addition to concerns about the smart phone strategy, analysts have also been concerned about the threats to Microsoft’s Windows operating system and Office franchises due to increasing popularity of tablet computers led by Apple’s iPad.  The failure of Microsoft’s Kin phone earlier this year has added to bearish sentiment although the Kin was intended for a much more targeted niche market and ran an older operating system.

We have outlined the bullish case for Microsoft based on the depressed valuation of the shares, positive recent financial results, and expected strong results this fiscal year due to a corporate refresh cycle that will take advantage of Windows 7 and Office 2010 after a period in which upgrades were delayed due to both real and perceived shortcomings in the Windows Vista operating system.  However, despite attractive fundamentals, the market is currently focused on smart phones and appears to be assuming that Microsoft’s new operating system will utterly fail to gain any meaningful share from Apple’s iPhone or Google’s Android operating system.

iPhone 4 vs. Windows Phone 7

While we have not personally observed a device running Windows Phone 7, there are many technical and functional reviews of the operating system that have been published.  One helpful video comparing the iPhone to Windows Phone 7 was published in late September by the website and appears below.

For RSS Feed Subscribers, please click on this link for the video and a related article on

From the video, it appears that Windows Phone 7 is a very different operating system from the iOS 4 system that runs Apple’s iPhone.  The ability of Windows Phone 7 to easily customize the home screen with “active” content rather than just with links to applications seems attractive, although the reported lack of fast app switching could be a deal breaker for some users.  Like any first release of software, Windows Phone 7 lacks some features that will be enhanced in the future.

Windows Phone 7 may not represent a breakthrough release that will rapidly gain market share, but it also does not appear to be entirely uncompetitive and should appeal to some consumers.  Given the steady drumbeat of negative sentiment on Microsoft, anything short of a total failure with the Windows Phone 7 rollout could represent a catalyst for investors to revisit the intrinsic value of the company’s core cash generating businesses.

Disclosure:  The author of this article owns shares of Microsoft Corporation.

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Microsoft Plans Debt Sale to Fund Dividends and Buybacks September 13, 2010

Microsoft shares were sharply higher in late trading today after Bloomberg reported that the company is planning to sell debt this year to pay for dividends and share repurchases.  Why would a company with nearly $37 billion in cash on the balance sheet need to issue debt in order to pay dividends or fund repurchases?  The answer is that much of Microsoft’s cash hoard is held overseas and the company would have to pay taxes on earnings that are repatriated to the United States.

A debt offering would also be quite cheap for Microsoft given the company’s strong credit rating and low interest rates.  Bloomberg cited an unnamed source at Microsoft who indicated that the company could raise at least $5 billion without jeopardizing the credit rating.  It is likely that Microsoft will obtain an interest rate below 4 percent, although we do not yet know what kind of debt maturities are under consideration.

Some analysts are predicting an even larger debt offering of up to $10 billion, although this is apparently higher than what company executives are considering.  Microsoft currently pays a 13 cent quarterly dividend and could increase the regular payout significantly or declare a special dividend as it did in 2004.  This would make sense for shareholders if the current 15 percent dividend tax rate is not extended by Congress and reverts to the ordinary income tax rate in 2011.

We recently profiled Microsoft and made many similar points regarding the potential for larger payouts and share repurchases based on the company’s low valuation.

Disclosure:  The author owns shares of Microsoft.

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Categories: Investing Microsoft

Technology CEOs View Dividends as Sign of Defeat September 12, 2010

Few examples in stock market history more clearly illustrate the risks of buying into “hopes and dreams” than the technology bubble of the late 1990s and early 2000s.  Companies with no earnings and nonsensical business plans eventually ceased to exist and are now long forgotten.  However, most of the well known technology firms from 2000 continue to exist today and have tested business models that generate consistent profitability.  However, investors are so disillusioned that valuations have plummeted.  This raises the question:  Are technology companies now “value stocks” that should pay large dividends?

The question of technology firms’ “payout problem” was the subject of an article this weekend in Barron’s.  Andrew Bary makes many of the familiar points regarding the valuation of companies such as Hewlett-Packard, Microsoft, Intel, and other former high fliers that now trade in value territory based on earnings multiples.  We recently published a favorable article regarding Microsoft making some similar points.  Barron’s points out that few technology companies are paying significant dividends. Intel’s 3.5 percent payout is an exception and Microsoft also pays a modest dividend of 2.2 percent but clearly the potential for much larger dividends exists.

Why Hoard Cash?  Look at the Incentives…

Why are technology CEOs so reluctant to pay dividends and prefer to pile up huge amounts of cash on the balance sheet?  The motivation behind cash hoarding for technology firms seems to fall into two categories.  First, technology CEOs have a mindset in which talk of growth is paramount.  Analysts expect this focus and “growth” investors will abandon a company that admits limits to growth by paying dividends.  Second, compensation plans for technology CEOs usually rely heavily on options with a fixed exercise price.  Paying large dividends reduces the intrinsic value of the options because cash is exiting the business.  Additionally, CEOs may believe that a permanent revaluation of the company as a slow growing “value” stock could prohibit multiple expansion that will increase the value of options.

However, the reality may be quite different in terms of how the market reacts to higher payouts.  Many investors are legitimately afraid of high levels of cash on the balance sheet due to  concerns that expensive acquisitions may be pursued.  HP’s acquisition of 3Par is the latest example.  Paying a larger percentage of free cash flow to investors could provide reassurance and also would impose discipline on management.

Barron’s also accurately points out that some investors will be attracted to technology companies based on larger payouts.  The incoming group of income oriented investors could very well make up for the exit of investors seeking “growth”.  As Warren Buffett and others have often said, the distinction between “growth” and “value” investing is a  false one to begin with.  Ultimately, management should retain earnings only when the prospect of internal reinvestment or acquisition exceeds a hurdle rate that is higher than what investors could achieve for themselves if they take possession of the excess cash.

Look at Share Ownership, not Option Holdings

While it is impossible to predict which technology companies will increase payouts going forward, one clue could involve the level of stock ownership by management.  If the CEO has a large ownership interest, as opposed to merely holding a large number of options, he or she would benefit from distribution of the cash just like other shareholders.  When Microsoft instituted a regular dividend in 2004 and paid a one-time special dividend of $3.00, many observers believed that this was due to Bill Gates and Steve Ballmer’s large ownership position in the company.

With the dividend tax set to increase in 2011, it would not be surprising to see special dividends paid out later this year.  Companies with high levels of insider ownership are much more likely to make such a move.

Disclosure:  The author of this article owns shares of Microsoft Corporation.

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Microsoft Promotes Cloud Capabilities in New CRM Release September 9, 2010

Microsoft announced a global beta of Microsoft Dynamics CRM 2011 today and appears to be heavily promoting the cloud capabilities of the new version.  In our recent article presenting the investment case for Microsoft, we pointed out that cloud computing is one of the major threats facing Microsoft and a mainstay of the bearish case against the company.  Let’s take a quick look at today’s announcement.

The Microsoft CRM product is a customer relationship management package that focuses mainly on sales, marketing, and help desk functions while integrating with Microsoft Office products.  The product is used either through the Internet Explorer browser or through a plug in for Microsoft Outlook.  Microsoft offers the product either as an on-premise solution installed by the customer or as a cloud-based hosted model. offers much of the same functionality but Microsoft has the advantage of tighter integration with the Microsoft Office suite of products.

While the technical details of the Microsoft CRM product are beyond the scope of this article, we believe that Microsoft’s release announcement today is important for at least two major reasons.  First, the release continues to advance very tight integration with Microsoft Office which still has a dominant market share in the corporate market despite attempts by Google and others to take market share.  Microsoft is using the large installed base of customers who are already familiar with Office to sell more specialized solutions like Microsoft CRM.  Second, we can see that the company is taking the threat of the cloud very seriously and has taken steps to position its product in a way that can attract customers interested in this deployment model.  One negative aspect of Microsoft’s approach is a tight coupling with the Internet Explorer browser and unclear product road map support for popular alternatives such as Firefox.

Microsoft appears to be pursuing product strategies that leverage the dominance of Microsoft Windows and Microsoft Office to attract customers who desire cloud based deployment but are also interested in leveraging their existing investment in Microsoft products and the easier learning curve associated with tight integration with Microsoft Outlook.  As we pointed out in our earlier write up of the company, this can present risk averse business clients with a less radical alternative that permits existing software investments to be leveraged rather than discarded in favor of an entirely new platform.

Disclosure:  The author of this article owns shares of Microsoft.

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